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Caveat emptor, quia ignorare non debuit quod jus alienum emit[1]

Startup company employees, many in the tech world, need to be aware of a model that financiers and insiders of (typically Delaware) business corporations use to misappropriate contributions employees have made, in the form of foregone salaries, cash spent to convert employee stock options into common stock, or the acquisition of common stock by non-insiders. At least two courts have passed on this scheme, and each has denied any relief to the disappointed employees.[2] The absence of judicial recourse for this form of minority-shareholder oppression enhances a potential employee’s need to understand the scheme before stepping into it.[3]

Three Problems for Startups

Relevant to our discussion, new tech startups have three challenges: (1) they need highly skilled and dedicated employees to develop, improve, and sell their new products for revenue; (2) they need to conserve cash, particularly given that sales may be less than the research-and-development costs, rent, salaries, sales commissions, and other expenses; and (3) they need access to capital, i.e., cash. Problems (1) and (2) can be addressed by figuring out a way to underpay highly skilled employees,[4] while problem (3), which is most critical, is that which motivates insiders to implement the stock scheme we describe below.

Underpaying Highly Skilled Employees

The startup can underpay highly skilled employees by using what appears to be a win-win compensation model of aligned interests. With this model, the startup pays the potential employee a reduced cash salary and, to make up for the reduced salary, grants the employee ownership rights in the startup through grants of common stock options. The employee can convert such options into common stock at an (often) ever-increasing exercise, or “strike,” price. The employee receives less cash on the front end of the employment, but may realize significantly more cash, as capital gain, upon selling ownership in the company. The startup saves cash on reduced salaries while spending no cash to issue securities, beginning with employee common stock options that convert, upon payment of the exercise price to the startup, into common stock. Thus, the interests of the employee and startup appear to be aligned: the employee’s efforts increase the startup’s enterprise value as a revenue-generating and, later, net-income-generating, money machine, and the employee sells ownership in the company for a capital gain. At least that is how insiders of the startup can and do sell it to non-insiders.

Procuring Capital

If the startup is soliciting employees, it most likely has raised some capital from one or more angel investors or private equity firms, which it uses to pay expenses, including salaries, rent, inventory, and materials. Private equity firms contribute capital (cash) to the startup for convertible preferred stock, usually combined with the right to name a director to the company’s board.

The “preferred” designation distinguishes the rights of preferred stockholders over the rights of the common stockholders. Preferences can impact distributions of the corporation’s earnings and distributions of assets upon liquidation of the corporation in bankruptcy. If the corporation cannot operate profitably and its assets are liquidated (turned into cash), as occurs in a bankruptcy, the cash is distributed to claimants in the following order: (1) first, to the corporation’s creditors (first, secured and then, unsecured), until they have recovered all principal and interest due; (2) second, to the corporation’s preferred stockholders, until they have recovered all the capital they contributed to the corporation (par value plus amounts paid in addition to par value);[5] and (3) third, to the corporation’s common stockholders, which includes employee stockholders. The priority in cash distribution that holders of preferred stock enjoy over holders of common stock is called a “liquidation preference.” If the company is in liquidation, odds are good that the corporation’s total assets are less than the total of all three groups’ claims against those assets, meaning that common stockholders are typically the greatest losers.

Insiders of the Corporation

Upon the first round of financing, the startup has three sets of insiders: (1) the product-originators or founders who usually hold a majority percentage (over 50%) of the company’s units (shares) of common stock; (2) the private equity firm(s); and (3) the primary officers and directors, including the chief executive officer, chief financial officer, chairman, and other members of the board of directors. Everyone else, including employees holding the corporation’s common stock options and common stock, are non-insiders—at least for the purpose of this discussion but not, it should be noted, with respect to insider trading prohibitions under the securities laws.

As privately owned corporations, startups are not transparent: they file no public reports and information concerning their assets, financing activities, and operations is available only to insiders.[6] The corporation’s articles of incorporation, original and as amended, can be difficult to obtain from the state that issued them, and employees or others investing in the company may not realize that what’s hidden in the articles may later prove to be of critical importance. Hence the caveat emptor in the title of this article.

Exiting the Corporation

Stockholders, preferred and common, can exit their investments in a privately held corporation in one of three ways: (1) through liquidation, discussed above; (2) through a public sale of common stock, often in an initial public offering (“IPO”),[7] sometimes accompanied by a secondary offering;[8] or (3) through a private sale of the corporation or its assets.

In terms of exit outcomes, the worst payout outcome for common stockholders is in liquidation because the preferred shareholders’ liquidation preference can prevent equal sharing of what remains after the creditors are paid out.

The best outcome for all stockholders, preferred and common, is an IPO or some equivalent, which creates a public market into which one’s common stock can be sold, most likely at a profit. Because the preferred stock is convertible, preferred stockholders convert their stock into common stock and sell their shares of now-common stock into the newly created public market for the corporation’s common stock.

The private sale would appear to be an intermediate outcome, which would inure to the benefit of the common stockholders but probably not be as lucrative as a public offering IPO. This is where the shenanigans can come in.

“Deeming” a Private Sale to be a Liquidation

In a private sale of the corporation, whether by merger or otherwise, the insiders decide to accept an offer to sell, and all stockholders, preferred and common, would presumably be treated equally. But the stock scheme we mentioned at the beginning of this article alters this default scenario if the board has inserted into the corporation’s articles of incorporation a so-called “deemed liquidation” clause.

By legal magic, the clause permits the corporation’s board of directors to “deem” a private sale of the corporation to be a liquidation of the corporation in order that the liquidation preference applies, which is solely for and to the benefit of the preferred stockholders. This wide-spread practice[9] thereby creates not one but two equally bad “worst-case” scenarios of the three possible scenarios. This fact, given that IPOs are very rare and the most common outcome for a startup company is bankruptcy or a private sale, means that the value of the common stock option, as a form of deferred compensation, may be approximately $0 per share. And where an employee has expended cash to convert such options into common stock, this may result in a net monetary loss for the employees.[10]

Unlike an actual liquidation, which is involuntary, the deemed liquidation allows insiders to choose to trigger liquidation consequences when entering into a private sale of the corporation for which they may receive a significant sales price. The insertion in the articles of incorporation of the deemed liquidation clause enables preferred stockholders to capture the contributed capital of the common stockholders, including employees’ share of contributed capital, leaving the common stockholders with no payout at the end of a successful exit via a private sale.

The “Value” of a Share of the Startup’s Common Stock

Although no market for a startup’s common stock exists, startups will pay purportedly independent valuation services to determine periodically (annually, at least) the “fair market value” of each share of the startup’s common stock. The process and resulting value are called the 409A[11] valuation, and it is used to price the stock option exercise price. Unless insiders disclose the existence and impact of the deemed liquidation clause and its material impact on the value of the common stock to the independent valuation service, the 409A valuation is almost certainly overstated. The corporation’s insiders, however, have no incentive to inform the valuation service about this clause, as it would not only diminish the employee recruitment and retention sweetener, but would also lower amounts employees would pay to exercise their stock options.

Why Would Founders and Majority Common Stockholders Permit This?

One important and overlooked point: if the common stock will pay out $0 per share, why would the founders or majority common stockholders agree to a private sale of the corporation and vote to trigger a deemed liquidation clause? Generally, one would assume that, as common shareholders and (usually) holders of a majority of the voting shares, the founders/insiders would have a counterincentive to agreeing to such an outcome since their shares would also be valued at $0 per share.

One way this has been addressed—with the help of clever, high-priced lawyers, of course—is through a side deal dressed up as a retention agreement. In this scenario, as part of the agreed private sale, the founders/insiders enter into a retention agreement between the acquiring corporation and the insiders who hold the majority of the voting common stock. The retention agreement “obligates” these stockholders (and other insiders) to remain with the corporation until the closing of the private sale and obligates the corporation to pay a stated amount of the total sales price to the retained insiders; no mention is made in this retention agreement of the actual quid pro quo—the insiders’ vote as majority holders of the common stock in return for cash payment to them upon the closing of the sale. This puts the common stockholder insiders identified in the retention agreement in an advantageous position as compared to the other, unprotected common stockholders: they will get paid much more than $0 per share of common stock (usually several million dollars under the retention agreement) before the preferred stockholders take the remainder. The other holders of common stock (i.e., the minority common stockholders), including current and former employees who exercised option grants and paid to obtain common stock—none of whom, of course, were included in the retention agreement—receive $0 per share of their common stock.

Conclusion

Employees hired by startups, including very senior employees, are often convinced to work for lower upfront salaries when paired with generous incentive compensation in the form of option grants or common stock allocations. The general premise that makes this work is that all will share in the eventual upside when any sale occurs, particularly a successful public sale via an IPO. The company’s founders market this vision while minimizing salaries to valuable employees. What the employees (and perhaps some founders) do not know until it is too late, however, is that legal chicanery will limit the eventual bonanza only to a select few—the founders themselves, should they succeed in holding on to the majority of the common voting shares in the company, and the financiers who manipulate the outcome to maximize their returns and minimize their losses—at the expense of others. For the money men (although they’re not all men), this is essentially a game to see who gets to walk away with the most marbles—and the more honest among them don’t deny this.

This article serves as a warning that the game can be rigged even when it doesn’t appear that way. The deemed liquidation clause in a company’s articles of incorporation can be inserted at any time and, so far, courts have chosen not to protect the minority holders of common stock from the deception that is or can be visited upon them.